Why Dollar Cost Averaging Works Well in a Volatile Market

When volatility comes to the stock market it is easy to let your emotions take hold of your actions. When you watch a lot of the ups and downs in the market, you can become scared and hold off on putting money into your investment and retirement accounts like you normally would. In the end this can mean thousands of dollars less in your retirement nest egg. To help fight against your emotions you can use dollar cost averaging through automatic payments to help bolster your retirement accounts in a volatile stock market. Here’s how and why to do that.

Photo by SqueakyMarmot via Flickr

What is Dollar Cost Averaging

There are two main ways to invest your money into a specific investment (such as a mutual fund). You can push all of your money into the mutual fund all at once, or you can trickle it in over a period of time. When you invest all of your money in one transaction you risk buying it at a higher price than if you trickled it in. Your target investment might have a spike in the price that lasts several days or weeks just when you put your money in, only to have it fall back to a lower price levelĀ  later. In this scenario you would be stuck with a higher cost in the investment than necessary.

With dollar cost averaging you trickle in your money into the investment over a period of time. It might be over a couple of weeks, or months. Let’s say you are trying to fund a Roth IRA with $5,000 this year. You could put $5,000 in your account on January 1st, or you could contribute $416.66 every month of the year. By contributing on a consistent schedule you invest at times when the price is high, but also at times when the price is low. The end result is your get an average investment cost rather than risking everything on one transaction.

Why Dollar Cost Averaging is Best for Volatile Environments

In a dream world we would all be able to contribute funds to our retirement on the day our specific investment is at its cheapest price. But no one has a crystal ball to know exactly when to put money into a specific investment.

With dollar cost averaging giving you an average investment price (rather than just one high price) it becomes extremely effective during volatile time. If the stock market is having a week of up 5% one day, down 3% the next day, and down 5% the day after you would have a variety of prices your investment could be priced at. If you fund your investment with dollar cost averaging you might invest 1/3 on each day and pay the high price the first day, but the lower prices the second and third day. The end result would be a lower average price in the investment than if you had contributed it all on the first day.

Setting Up Dollar Cost Averaging

Investment companies make it simple for you to dollar cost average. Using an automatic investment plan, you can decide how much and how often you want to contribute, and the company will withdraw the money from your bank account on your schedule. If you can only afford to invest $100 per month, just set up automatic contributions for that amount to be invested on a monthly basis.

At the end of the day you could potentially get a lower investment cost by only investing on the cheapest days of the year, but it is impossible to know when that is. With dollar cost averaging you are accepting taking the average cost of the investment throughout the year. In this case being average is your best bet.

About the Author

By , on Sep 21, 2011
Kevin Mulligan
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He's building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.

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Leave Your Comment (2 Comments)

  1. Not a bad guide to dollar cost averaging; it is definitely quite helpful for the most part. Although I’ve read more than one source that notes that if you dollar cost average rather than investing a lump sum (if, say, you get a large amount as an inherited sum), it’s generally better to invest it right away than spreading out the investment; your invested money is more likely to rise than fall, so getting a start on things is generally for the best. It’s interesting to hear the different opinions on such matters, I suppose.

  2. krantcents says:

    I always dollar cost average into the market(once a month)! Over time it can be meaningful.

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